Chapter 10 PPT

Transcript Chapter 10 PPT

Chapter 10

Capital-Budgeting Techniques and Practice

Learning Objectives

1. Discuss the difficulty encountered in finding profitable projects in competitive markets and the importance of the search.

2. Determine whether a new project should be accepted or rejected using the payback period, net present value, the profitability index, and the internal rate of return.

3. Explain how the capital-budgeting decision process changes when a dollar limit is placed on the capital budget. 4. Discuss the problems encountered when deciding among mutually exclusive projects. Copyright ©2014 Pearson Education, Inc. All rights reserved.

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FINDING PROFITABLE PROJECTS

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Capital Budgeting

• Meaning: The process of decision making with respect to investments in fixed assets— that is, should a proposed project be accepted or rejected.

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Source of Ideas for Projects

• R&D: Typically, a firm has a research & development (R&D) department that searches for ways of improving existing products or finding new projects.

• Other sources: Employees, Competition, Suppliers, Customers.

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CAPITAL-BUDGETING DECISION CRITERIA

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Capital-Budgeting Decision Criteria

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The Payback Period

• Meaning: Number of years needed to recover the initial cash outlay related to an investment.

• Decision Rule: Project is considered feasible or desirable if the payback period is less than or equal to the firm two projects.

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Payback Period Example

Example: Project with an initial cash outlay of $20,000 with following free cash flows for 5 years.

YEAR CASH FLOW BALANCE Payback is 4 years.

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Trade-Offs

• Benefits: – Uses cash flows rather than accounting profits – Easy to compute and understand – Useful for firms that have capital constraints • Drawbacks: – Ignores the time value of money – Does not consider cash flows beyond the payback period Copyright ©2014 Pearson Education, Inc. All rights reserved.

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Discounted Payback Period

• The discounted payback period is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted cash flows.

• The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows.

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Discounted Payback Period

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Table 10-2

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Payback Period Example

• Table 10-2 shows the difference between traditional payback and discounted payback methods.

• With undiscounted free cash flows, the payback period is only 2 years, while with discounted free cash flows (at 17%), the discounted payback period is 3.07 years.

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**Net Present Value (NPV)**

• NPV is equal to the present value of all future free cash flows less the investment project in today ’ s dollars. ’ s initial outlay. It measures the net value of a Copyright ©2014 Pearson Education, Inc. All rights reserved.

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NPV Example

• Example: Project with an initial cash outlay of $60,000 with following free cash flows for 5 years.

Year FCF

Initial outlay –60,000 1 – 25,000

Year

3 4

FCF

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NPV Example

• • PV of FCF = $60,764 • Subtracting the initial cash outlay of $60,000 leaves an NPV of $764. • Since NPV > 0, project is feasible.

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NPV in Excel

 • Input cash flows for initial outlay and free cash inflows in cells A1 to A6.

• In cell A7 type the following formula:

=A1+npv(0.15,A2:A6)

• Excel will give the result NPV = $764.

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NPV Trade-Offs

• Benefits – Considers all cash flows – Recognizes time value of money • Drawbacks – Requires detailed long-term forecast of cash flows • NPV is generally considered to be the most theoretically correct criterion for evaluating capital budgeting projects.

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The Profitability Index (PI) (Benefit-Cost Ratio)

• The profitability index (PI) is the ratio of the present value of the future free cash flows (FCF) to the initial outlay. • It yields the same accept/reject decision as NPV.

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Profitability Index

• Decision Rule:

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Profitability Index Example

• A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $50,000.

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Profitability Index Example

FCF

–$50,000 PVF @ 10% 1.000

–$50,000 15,000 8,000 10,000 12,000 14,000 16,000 0.909

0.826

0.751

0.683

0.621

0.564

13,636 6,612 7,513 8,196 8,693 9,032 10-22

Profitability Index Example

PI = ($13,636 + $6,612 + $7,513 + $8,196 + $8,693 + $9,032) / $50,000 = $53,682/$50,000 = 1.0736

Project ’ s PI is greater than 1. Therefore, accept.

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NPV and PI

• When the present value of a project cash outlay, the project NPV will be ’ s free cash inflows are greater than the initial positive. PI will also be greater than 1.

• NPV and PI will always yield the same decision.

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**Internal Rate of Return (IRR)**

• IRR is the discount rate that equates the present value of a project ’ s future net cash flows with the project ’ s initial cash outlay (IO).

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Internal Rate of Return

• Decision Rule:

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Figure 10-1

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***IRR* and *NPV***

• If NPV is positive, IRR will be greater than the required rate of return • If NPV is negative, IRR will be less than required rate of return • If NPV = 0, IRR is the required rate of return.

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IRR Example

• Initial Outlay: $3,817 • Cash flows: Yr. 1 = $1,000, Yr. 2 = $2,000, Yr. 3 = $3,000

Discount rate NPV

15% $4,356 20% $3,958 22% $3,817 • IRR is 22% because the NPV equals the initial cash outlay at that rate.

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IRR in Excel

 • IRR can be easily computed in Excel.

• In the previous example, input cash outflow and three yearly cash inflows in cells A1:A4.

• In cell A5 input

=IRR(A1:A4)

• Excel will give the result IRR = 22%.

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**Multiple IRRs**

• A normal cash flow pattern for project is negative initial outlay followed by positive cash flows (–, +, +, + …) • However, if the cash flow pattern is not normal (such as –, +, –) there can be more than one IRR.

• Figure 10-2 is based on cash flows of –1,600, +10,000, –10,000 in years 0, 1, 2.

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**Multiple IRRs (Figure 10-2)**

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**Modified IRR (MIRR)**

• Primary drawback of the IRR relative to the net present value is the reinvestment rate assumption made by the internal rate of return. Modified IRR allows the decision maker to directly specify the appropriate reinvestment rate.

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Modified IRR

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MIRR Example

• Project having a 3-year life and a required rate of return of 10% with the following free cash flows: Initial Outlay Year 1

FCFs

–$6,000 Year 2

FCFs

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MIRR Example

• Step 1: Determine the PV of the project present.

project value.

’ the project ’ s required rate of return to calculate the FV of the project ’ inflows. They turn out to be $2,420 + ’ s free cash outflows. $6,000 is already at the • Step 2: Determine the terminal value of the s free cash inflows. To do this use s three cash $3,300 + $4,000 = $9,720 for the terminal Copyright ©2014 Pearson Education, Inc. All rights reserved.

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MIRR Example

• Step 3: Determine the discount rate that equates the PV of the terminal value and the PV of the project ’ s cash outflows. MIRR = 17.446%. • Decision: MIRR is greater than required rate of return, so accept.

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MIRR in Excel

 = MIRR(values,finance rate,reinvestment

rate)

where values is the range of cells where the cash flows are stored, and k is entered for both the finance rate and the reinvestment rate.

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CAPITAL RATIONING

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Capital Rationing

• Capital rationing refers to situation where there is a limit on the dollar size of the capital budget. This may be due to: a) temporary adverse conditions in the market; b) shortage of qualified personnel to direct new projects; and/or c) other factors such as not being willing to take on excess debt to finance new projects.

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Capital Rationing

• How to select? Select a set of projects with the highest NPV—subject to the capital constraint. • Note, using NPV may preclude accepting the highest ranked project in terms of PI or IRR.

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Figure 10-4

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Table 10-7

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RANKING MUTUALLY EXCLUSIVE PROJECTS

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Ranking Mutually Exclusive Projects

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Size Disparity

• This occurs when we examine mutually exclusive projects of unequal size.

• Example: Consider the following cash flows for one-year Project A and B, with required rates of return of 10%.

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Table 10-8

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Size-Disparity Ranking Problem

NPV PI IRR

Project A 72.73

1.36

50%

Project B 227.28

1.15

27%

Ranking Conflict: – Using NPV, Project B is better; – Using PI and IRR, Project A is better.

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Size-Disparity Ranking Problem

• Which technique to use to select the project?

• Use NPV whenever there is size disparity. If there is no capital rationing, project with the largest NPV will be selected. When capital rationing exists, rank and select set of projects based on NPV.

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The Time-Disparity Problem

• Time-disparity problem arises because of differing reinvestment assumptions made by the NPV and IRR decision criteria.

• How are cash flows reinvested?

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The Time-Disparity Problem

• Example: Consider two projects, A and B, with initial outlay of $1,000, cost of capital of 10%, and following cash flows in years 1, 2, and 3: • A: $100 $200 $2,000 • B: $650 $650 $650 Copyright ©2014 Pearson Education, Inc. All rights reserved.

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The Time-Disparity Problem

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The Time-Disparity Problem

NPV PI IRR

Project A

758.83

1.759

35% Project B 616.45

1.616

43%

• Ranking Conflict: – Using NPV or PI, A is better – Using IRR, B is better • Which technique to use to select the superior project? – Use NPV Copyright ©2014 Pearson Education, Inc. All rights reserved.

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Unequal-Lives Problem

• This occurs when we are comparing two mutually exclusive projects with different life spans.

• To compare projects, we compute the Equivalent Annual Annuity (EAA).

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Unequal-Lives Problem

• Example: If you have two projects, A and B, with equal investment of $1,000, required rate of return of 10%, and following cash flows in years 1-3 (for project A) and 1-6 (for project B) • Project A = $500 each in years 1-3 • Project B = $300 each in years 1-6 Copyright ©2014 Pearson Education, Inc. All rights reserved.

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Computing EAA

• Calculate the project ’ s NPV: A = $243.43 and B = $306.58

• Calculate EAA = NPV/annual annuity factor A = $97.89

B = $70.39

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Figure 10-5

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Figure 10-6

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Key Terms

• Capital budgeting • Capital rationing • Discounted payback period • Equivalent annual annuity (EAA) • Internal rate of return (IRR) • Modified internal rate of return (MIRR) • Mutually exclusive projects • Net present value (NPV) • Net present value profile • Payback period • Profitability index (PI) or benefit-cost ratio Copyright ©2014 Pearson Education, Inc. All rights reserved.

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Table 10-1

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Table 10-3

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Table 10-4

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Table 10-5

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Table 10-6

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Table 10-10

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Table 10-10 (cont.)

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Figure 10-3

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Chapter 10 PPT

Transcript Chapter 10 PPT

Chapter 10

Learning Objectives

FINDING PROFITABLE PROJECTS

Capital Budgeting

Source of Ideas for Projects

CAPITAL-BUDGETING DECISION CRITERIA

Capital-Budgeting Decision Criteria

The Payback Period

Payback Period Example

Trade-Offs

Discounted Payback Period

Discounted Payback Period

Table 10-2

Payback Period Example

Net Present Value (NPV)

NPV Example

NPV Example

NPV in Excel

NPV Trade-Offs

The Profitability Index (PI) (Benefit-Cost Ratio)

Profitability Index

Profitability Index Example

Profitability Index Example

Profitability Index Example

NPV and PI

Internal Rate of Return (IRR)

Internal Rate of Return

• Decision Rule:

Figure 10-1

IRR and NPV

IRR Example

IRR in Excel

Multiple IRRs

Multiple IRRs (Figure 10-2)

Modified IRR (MIRR)

Modified IRR

MIRR Example

MIRR Example

MIRR Example

MIRR in Excel

CAPITAL RATIONING

Capital Rationing

Capital Rationing

Figure 10-4

Table 10-7

RANKING MUTUALLY EXCLUSIVE PROJECTS

Ranking Mutually Exclusive Projects

Size Disparity

Table 10-8

Size-Disparity Ranking Problem

Size-Disparity Ranking Problem

The Time-Disparity Problem

The Time-Disparity Problem

The Time-Disparity Problem

The Time-Disparity Problem

Unequal-Lives Problem

Unequal-Lives Problem

Computing EAA

Figure 10-5

Figure 10-6

Key Terms

Table 10-1

Table 10-3

Table 10-4

Table 10-5

Table 10-6

Table 10-10

Table 10-10 (cont.)

Figure 10-3

Directory

**Net Present Value (NPV)**

**Internal Rate of Return (IRR)**

***IRR* and *NPV***

**Multiple IRRs**

**Multiple IRRs (Figure 10-2)**

**Modified IRR (MIRR)**